The Bitcoin options market continues to grow with the bullish growth of the leading cryptocurrency led by institutional structures. However, while many use options to hedge their positions, the large number of Bitcoin options that expire in a few days could by themselves lead to sharp price fluctuations as we approach the end of January.
A call option gives the holder the right, but not the obligation, to buy the underlying asset at a predetermined price on a specified date or earlier. A put option is a put option. An Out of the Money (OTM) call is a call that has a strike that exceeds the spot price. At time of publication, call options at a strike price above the current $ 34,500 spot price are OTM. Meanwhile, put options with strikes below the spot price are also OTMs.
Market makers can cause volatility
The expiration of an option rarely has a direct impact on the spot price. However, when open interest focuses on out-of-the-money (OTM) call and put options, as is the case with Bitcoin, the sudden move before expiration forces market makers to hedge the underlying asset. This leads to more significant price turbulence.
Over 80% of the open interest with an expiration on Jan 29, based on Deribit will expire out of the money or become worthless. Notably, over 52,600 call contracts and 29,800 put contracts are currently OTMs, according to Swiss data provider Laevitas.
"If BTC rises quickly to record highs over the next few days, market makers are expected to aggressively hedge their out-of-the-money short call positions, which is likely to increase overall market volatility and base price momentum." - Samnit Chepal , a quantitative analyst at Ledger Prime.
Market makers are individuals or member firms that create liquidity in the market and take the opposite side of a transaction initiated by traders / investors. In Chepal's view, given the recent bullish sentiment and massive buying of higher strike and out-of-the-money call options, market makers across the board are likely to have a clean short range (sellers of the call).
The gamut of options is the rate at which the delta changes when the bitcoin price changes by $ 1. Delta measures the sensitivity of option prices to changes in the price of the spot market.
To be short range means to be an option writer, whether it is a call or a put. In this case, market makers have a short gamut due to selling calls. This makes them vulnerable to a sudden transition to the higher side.
Consequently, if Bitcoin rallies ahead of Friday's expiration, market makers could aggressively hedge their OTM short call positions by going long in the spot market, leading to increased price volatility and increased bullish momentum.
If Bitcoin jumps to record highs above $ 42,000 ahead of Friday, market makers are likely to take action as much of the open interest is concentrated in higher strike price claims. “Much of the open interest comes from deeper OTM call strikes above $ 44,000,” Chepal said.
“In an effort to protect against an out-of-the-money outcome, options traders can probably resort to delta hedging strategies,” said Sui Chung, CEO of CF Benchmarks.
Delta hedging includes several positions (long and short, call / put) aimed at reducing, hedging the directional risk associated with the movement of the underlying asset prices.
For example, the delta for a $ 40,000 call expiring on Jan 29 is currently 0.10. This means that the option price will change by $ 0.10 for every $ 1 change in the bitcoin price.
Another way to look at this is that investors who currently hold a long call position with a strike at $ 40,000 have a BTC delta risk of 0.10. To hedge against risk, traders can short sell 0.10 BTC in the spot or futures market, or buy a 0.10 delta put option.
Option traders usually hedge delta options. However, during particularly tough times, they may resort to hedging with the underlying asset itself, Chang said, leading to increased price volatility.
“This could create a vicious circle in which increased volatility will lead more derivatives traders to rush to the same hedging strategies, ultimately having the same effect as pouring oil into an open fire,” Chang said.
According to the data, bitcoin is currently trading at about $ 34,100, having dropped below $ 29,000 last week. As long as these options remain open in the market, the next couple of days could be interesting - and possibly volatile - for Bitcoin.